Checklist for investing in tax-free bonds

For liquidity, bonds can be sold and bought in the secondary market unlike FDs which have to be surrendered to the bank. The key difference between an FD and a bond is that the principal amount in bonds is not guaranteed, except on maturity. In the interim, you may get an amount less or more than the investment amount in case you sell.

While bank FDs can be made at any time, investment in new tax-free bonds can be done only at a specific time—when the issue is open for subscription. You may need to keep the funds ready in advance as the bonds often get oversubscribed soon. If you are serious about grabbing the tax-free bonds, you will have to put in your application on the very first day. Considering the larger size of issues these days and a lower coupon rate compared to past, you will have a better chance to succeed in getting the bonds. When companies start private placements (not for retail investors), they initially have to struggle, which indicates a lower interest among subscribers. If you really do not make it and are still eager to buy tax-free bonds, the secondary market is the place. Here are the various factors you should keep in mind before subscribing to tax-free bonds or buying them in the secondary market:

1. Convenience of Tax Payment: When you buy tax-free bonds, the interest is automatically credited to your bank savings account (linked to your demat account) and because interest on the bonds is exempt from taxes, you don’t have to worry about tax calculations and payment of advance tax. Compared to this, if your interest from bank FD exceeds Rs10,000 in a financial year, the bank will deduct 10% as TDS (tax deducted at source). If you are in the tax bracket of 20% or 30%, you will have to pay additional tax either at the end of the financial year or as advance tax.

If the total tax liability from FD interest or any other income exceeds Rs10,000 in a financial year, you will end up paying advance tax thrice in a financial year (September 15th - 30%, December 15th - 60% and March 15th - 100% of the tax due in the financial year). If you underpay the advance tax dues by more than 10%, you have to pay penal interest when you file your tax returns.

2. Liquidity: Premature withdrawal of FD will give the principal back along with interest calculated at the interest rate for the period minus 1%. On the other hand, the principal amount for bonds is not guaranteed except at maturity. If you try to sell the bonds before the maturity date, you may get an amount higher or lower than the issue price, depending on the interest rates prevalent at that time. If you hold the bonds to maturity, you will get back the issue price. Tax-free bonds can be viewed as a way to diversify your debt portfolio.

3. Trading Option: While the long maturity of the bonds (10 to 20 years) may put you off, many may want to sell the bonds after holding them for a short period. If interest rates decline, the bond value will rise. But this assumption may or may not hold good. There will be varying impact on bonds based on the risk perception of the market about the bonds and their issuer. One key factor for assessing whether to go for tax-free bonds now or later is a call on the movement of interest rates. If you feel that the rate cycle has peaked, it is a good time to subscribe or buy bonds in the secondary market. If you are willing to hold the purchased bonds for the full term, the fluctuations in the interest rates should not bother you. If you do not plan to hold them to maturity, sell the bonds when the rate of interest is low. Liquidity in the secondary market for bond trading can vary but high rated bonds (AA+ and above) will find buyers. Selling bonds in the secondary market is subject to capital gains tax. Only the interest on them is non-taxable.

4. Step-down Clause: Under this clause, the coupon rate goes down automatically, if the investor sells the bonds in the secondary market. This means a lower selling price. The step-down feature is obviously to encourage genuine investors to subscribe and discourage those trying to make a quick buck by selling them in the secondary market.



5. Cumulative Interest: Tax-free bonds will pay half-yearly or yearly interest which you may want to plough back in a bank FD or any other debt fund, if you want to earn on the interest income as well. A cumulative FD does not carry interest re-investment risk. It assures you that the quarterly interest (which has to be compounded) is re-invested at the same interest rate, to help you increase the yield. One drawback with cumulative FDs is that you have to pay tax on the interest that you don’t receive in hand. You get the interest only on maturity of the cumulative FD, but tax on the accrued interest is payable for each financial year in which it accrues.

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